* Euro zone stock rally looks overdone heading into results
* Selective picks in Spain and Italy favoured over Portugal
By Alistair Smout
LONDON, Jan 17 (Reuters) - European fourth-quarter earningsare set to disappoint consensus expectations, according to themost accurate analysts, potentially threatening the new yearstock rally focused on Spain and Italy.
Strong gains in 2012 and 2013 have left many Europeanindexes looking fully valued, and most analysts predict thatearnings will need to improve this year if double digit gainsfor equities are to be repeated.
However, Thomson Reuters SmartEstimates, which weight themost accurate company analysts more heavily than consensus,predict that STOXX Europe 600 fourth-quarter earningswill miss consensus by 0.8 percent and fall 1.6 percent year onyear, with Friday's profit warning from Shell (LSE: RDSB.L - news)underscoring the potential for poor results.
Moreover, broad-based January gains for the euro zoneperiphery - which saw bourses in Spain, Italy and Portugal risebetween 5 and 8 percent already in 2014 on expectations of aneconomic recovery - could start to appear overdone, with theirearnings likely to features some big misses from their banks.
The earnings season could deliver sufficiently bad resultsin peripheral Europe over the next few weeks to push investorsback into safe-haven German stocks, which are forecast to seeresilient profit growth.
"It may be a little bit too early for Europe to show us thisstrong recovery in earnings. It could be a rocky period forsentiment as there's a wait for the earnings to turn up," NickNelson, European equity strategist at UBS (Xetra: UB0BL6 - news) , said.
Euro zone banks, seen as a proxy for a pick-up in domesticeconomic activity and benefiting from relative calm in thesovereign debt market, are up 10 percent this year.
However, with top analysts predicting some banks could missconsensus forecasts by as much as 16 percent and credit spreadswidening, the sector could be in for a reality check.
Chris Parkinson, head of research at Christopher StreetCapital (Other OTC: CGHC - news) , part of GFI Group (NYSE: GFIG - news) , said the earnings season couldprompt banks' share prices to fall to close the gap with thecredit market, which is pricing in greater risk for the sector.
"Earnings momentum is starting to see some deterioration inEurope ... if that continues heading into earnings season, thenthere is a big risk that companies which have small misses couldcause a serious sell-off, as the market is so bid up," he said.
In the last 30 days, 53 percent of analysts who have changedtheir view on Spanish stocks have downgraded forecasts, ThomsonReuters StarMine data showed. For Italy, the proportion isnearly 70 percent.
"That's not conducive for a credible rise in equity," JamesButterfill, global equity strategist at Coutts, said, referringto Spain and citing concerns the market was looking expensive.
The Spanish blue chip IBEX trades at a forward12-month price to earnings ratio of 14.2 times, the highest inEurope and at its most expensive since 2004. Analysts sayvaluations are unlikely to rise much further, meaning thatprices can only continue to increase if earnings do too.
Portugal also looked fully valued, Butterfill said, andwhile Italian stocks are a bit cheaper, they also populate thelist of companies set to miss consensus estimates by the most.
While prospects for euro zone peripheral banks in generalmay not be overly optimistic, selective investors could benefitfrom better earnings from banks able to benefit from improvedprospects for the region.
Spain's BBVA (Amsterdam: BBV.AS - news) leads peripheral banks with an 8percent consensus beat predicted by top analysts, with Santander and Italian lenders UniCredit (Berlin: CRIH.BE - news) and BancoPopolare also likely to beat forecasts.
Companies in Italy and Spain could also benefit from arelatively low exposure to emerging markets, said Dennis Jose,strategist at Barclays (LSE: BARC.L - news) . Falling demand and weak currencies indeveloping economies hit third-quarter profits for some Europeanblue chips.
However, after the run-up in those markets, earnings missescould see investors once again flee the periphery, and head backto the region's safe-haven the German DAX, where topanalysts predict that earnings will grow by 14.8 percent.
"If earnings aren't great, investors will look back to thecore, and Germany would be one of our favoured markets," Nelsonat UBS said.
- Europe News